Flow-Driven ESG Returns

Abstract

The returns from sustainable investing are strongly driven by price pressure from flows towards sustainable funds, causing high realized returns that do not reflect high expected returns. Using a structural model, I estimate investors’ ability to accommodate the demand from sustainable funds, which is given by their elasticity of substitution between stocks. I show that every dollar flowing from the market portfolio into sustainable mutual funds increases the aggregate value of green stocks by $0.4. The price pressure from flows supports the effectiveness of impact investing by lowering green firms’ cost of capital. In the absence of flow-driven price pressure, sustainable funds would have underperformed the market from 2016 to 2021. To this end, I develop a new measure of total capital flows into managed portfolios. The price pressure from total ESG flows is highly correlated with empirically observed returns, both in the time-series and in the cross-section. I support the structural estimates with reduced-form evidence, showing that index inclusions and mandate-driven portfolio additions by sustainable mutual funds significantly boost the prices of green stocks.

Keywords: sustainable investing, ESG, price pressure, flows, demand elasticity

JEL Classification: G11, G12, G23